Engagement letters for the individual tax practitioner

Tighten language limiting your professional liability.

Professional liability insurance carriers and defense attorneys have
always proclaimed that engagement letters are one of the first lines
of defense in a malpractice cause of action against a CPA. After all,
when drafted properly, engagement letters form the basis for an
enforceable contract and should have caveats unique to the scope of
service provided, the amount of risk inherent in the engagement, and
the need to satisfy professional standards.

The authors have seen a resurgence in the popularity and use of
engagement letters, coupled with a renewed interest in having
engagement letters reviewed and critiqued by risk management
professionals. The objective of this article is to develop an
understanding of the fundamentals of engagement letters and to suggest
provisions that will help minimize legal liability faced by CPAs.

The majority of claims (by frequency) reported by leading CPA
professional liability carriers (see Exhibit 1) stem from tax
services, yet, according to the authors’ employer, the North American
Professional Liability Insurance Agency LLC (NAPLIA), and their
experience, individual tax engagements are where engagement letters
are least used.

Faced with this historical pattern of claim behavior, it would
behoove CPA firms to tighten their individual tax engagement letters
and begin with the following fundamental objectives:

Address the letter to the appropriate parties in a formal
introductory paragraph. Exclude any children of the client or other
entities owned by the individual tax client and include the
appropriate year or years that are being prepared.

Identify which returns are being prepared, and do not combine
multiple returns. (For example, do not include a gift tax return
service with an individual tax service unless the proper disclaimer
language for a gift tax return is included.) The following language is
highly recommended. It and most of the following passages are from or
based on a full sample engagement letter available here:

We will prepare your [Year] joint federal income tax return and
income tax returns for the states of _______________
(collectively, the “returns”). This engagement pertains only to
the [Year] tax year, and our responsibilities do not include
preparation of any other tax returns that may be due to any taxing
authority.

Due to the increased focus by many state taxing authorities on
applying the nexus rules to a particular taxpayer and the resulting
potential for malpractice, the following clause is also highly recommended:

Our services are not intended to determine whether you have
filing requirements in other taxing jurisdictions than the one(s)
you have informed us of. Our firm is available under the terms of
a separate engagement letter to provide a nexus study that will
enable us to determine whether any other state tax filings are required.

While many tax organizers and the affirmations made on Schedule
B, Interest and Ordinary Dividends, of Form 1040, U.S.
Individual Income Tax Return, help in defending claims that
allege a failure to advise a client with respect to foreign bank
account returns (FinCEN Form 114 (formerly TD F 90-22.1), Report
of Foreign Bank and Financial Accounts (FBAR)), the optimal
defense is strong and clear engagement letter language that is signed
by the client(s). This area presents unique risks, as both civil and
criminal liability can arise for the CPA. With the IRS placing much
focus in this area, practitioners should address foreign bank accounts
in the letter itself.

A jurisdiction clause such as the one below is critical in an
engagement letter for out-of-state clients. If such a clause is not
used, the following could occur:

Example. Firm A, which has its only office in New
York state, prepares a tax return for a New Jersey resident client
(Client B). Client B sues Firm A, alleging improper advice regarding
the real estate professional rules and regulations. The lawsuit is
commenced and filed in Hudson County, N.J., where Client B resides.
New Jersey has a six-year statute of limitation for accountants’
negligence, while New York has a three-year statute. By not having
insisted on New York state jurisdiction, the firm has extended the
statute by at least three years. Below is a sample jurisdiction clause:

Notwithstanding anything contained herein, both accountant and
client agree that regardless of where the client is domiciled and
regardless of where this Agreement is physically signed, this
Agreement shall have been deemed to have been entered into at
Accountant’s office located in [Specific County], [Specific
State], USA, and [Specific County], [Specific State], USA, shall
be the exclusive jurisdiction for resolving disputes related to
this Agreement. This Agreement shall be interpreted and governed
in accordance with the Laws of [State].

Payment terms, retainers, late charges, additional fees, and
stop-work provisions for nonpayment need to be addressed. Clarity and
diligence must be adhered to in this section, as many professional
liability lawsuits, state board ethical complaints, and loss of
clients have resulted from misunderstanding these provisions. Too
often, only a phrase such as the following is used in a standard letter:

Our fee for services will be at our standard billing rates for
personnel assigned to this engagement [or fixed fees to cover
other than hourly fee arrangements]. Payment is expected when our
services are complete.

Eliminate confusion, loss of clients, and financial damages by
considering the following enhancements to the typical, limited clause above:

Delineate the payment terms.

Stipulate that a retainer will be required and will be applied
toward the final fee and that the retainer is not an estimate of the
fee charged for services.

Identify when payment is expected.

Provide for a termination of services if the fee is not paid in full.

Use an additional charge clause for services not originally contemplated.

Include a provision for reimbursement for out-of-pocket expenses
such as travel, special delivery, etc.

Shortcuts should be avoided, as this is one of the more common
areas causing professional liability lawsuits. Further, CPAs should be
paid timely for their work.

Due to the need to preserve data security and client confidentiality
in this age of electronic communication, this exposure should be
identified in the engagement letter. A clause to help minimize this
exposure follows:

In connection with this engagement, we may communicate with you
or others via email transmission. As emails can be intercepted and
read, disclosed, or otherwise used or communicated by an
unintended third party, or may not be delivered to each of the
parties to whom they are directed and only to such parties, we
cannot guarantee or warrant that emails from us will be properly
delivered and read only by the addressee. Therefore, we
specifically disclaim and waive any liability or responsibility
whatsoever for interception or unintentional disclosure of emails
transmitted by us in connection with the performance of this
engagement. In that regard, you agree that we shall have no
liability for any loss or damage to any person or entity resulting
from the use of email transmissions, including any consequential,
incidental, direct, indirect, or special damages, such as loss of
revenues or anticipated profits, or disclosure or communication of
confidential or proprietary information.

The value of tax organizers in defending a CPA in a professional
liability claim cannot be overstated; however, many practitioners
complain that their clients do not complete the organizer and at times
return it unopened. As a result, CPAs need to push back and have the
client take responsibility for the data. Engagement letter language
should establish this responsibility:

We will prepare the returns from information which you will
furnish to us. It is your responsibility to provide all the
information required for the preparation of complete and accurate
returns. We will furnish you with questionnaires and/or worksheets
as needed to guide you in gathering the necessary information.
Your use of such forms will assist us in keeping our fee to a
minimum. To the extent we render any accounting and/or bookkeeping
assistance, it will be limited to those tasks we deem necessary
for preparation of the returns

Each firm has its own comfort level with respect to risk, and every
client relationship varies. For this reason, many more areas should be
explored for engagement letters than this article can address. (See
“Engagement Letter Checklist,” below for other key issues engagement
letters should address.)

Before using any engagement letter in their practice, CPAs should
retain an attorney knowledgeable about the accounting industry, their
practice, and the laws of any jurisdiction(s) within which they
practice, to ensure the document’s maximum usefulness and compliance
with applicable laws and professional standards.

Engagement letters are one of the first lines of defense in an
accountant’s professional liability lawsuit. If drafted properly, they
are immeasurably valuable in heading off claims and resolving client distractions.

Exclusion clause. Because tax services can be
broad, an exclusion clause that identifies what services will
not be provided can be invaluable. For example, a payroll tax
preparation engagement might exclude independent contractor
classifications, labor regulations, ERISA (Employee Retirement Income
Security Act) compliance, and the reasonableness of officers’ compensation.

Deadline for submitting return information.
Establishing a date by which the client must provide the firm
information needed to prepare the return is essential.

Stop-work provisions. Although stop-work
provisions are typically used for nonpayment of fees, CPAs should
consider them for conflicts of interest and clients who provide tax
information late, refuse to take the CPA’s advice, or act unethically.

Limitation on use of the returns. Clients may
submit tax returns to third parties in lieu of a financial statement,
for which potential liability can be addressed through a clause
limiting returns’ use and distribution.

Tax position clauses. Many times, what the client
thinks is acceptable will conflict with professional standards.
Establish language stating that tax positions taken must satisfy
professional standards.

Supporting documentation. Because an examination
is always possible, remind clients of their responsibility to maintain
adequate records to support the deductions claimed on the return.
Include the proper length of time for which the records should be maintained.

Taxing authority examination. Representing a
client in an examination may be more involved than the return
preparation itself, for which many CPAs may not feel equipped. A
representation should be covered by the terms of a separately signed
engagement letter.

Outcome or results. The engagement letter is a
contract and not a marketing device. Particularly with amended tax
return and tax audit engagements, do not guarantee outcome or results.

Successor and assigns. To prevent having to ask
clients to sign an additional engagement letter if the firm is
acquired by another firm, include successor-and-assigns language.

Limitation of liability, consequential damage disclaimers, and
limiting the period to commence a lawsuit. While
these clauses are state-specific, their use should not be overlooked.

Alternative dispute resolution (ADR). Coupled with
insurance policy benefits (possible reduced deductibles), ADR is one
of the best lines of defense against CPA malpractice claims.

Indemnification and hold-harmless clauses. Third
parties are not bound by engagement letters, and many professional
liability claims result from third-party suits. Often, the CPA can be
reimbursed for losses by implementing indemnification and
hold-harmless clauses. A common indemnification is for time spent in
providing testimony in tax investigations and inquiries.

Review of prior-year returns. State that you are
responsible only for positions taken on the current-year return and
not for those on returns for previous years prepared by another firm
or preparer.

EXECUTIVE SUMMARY

Tax engagement letters are an important defense
against a malpractice cause of action against a CPA tax adviser or preparer.

Letters should be individually tailored for the year,
type of return of the engagement, and taxing jurisdiction(s). They
should acknowledge that the client may have filing requirements in tax
jurisdictions other than the one or ones identified to the CPA.

Another area engagement letters should address is foreign
financial accounts, since the IRS has been increasing its
enforcement efforts in this area. A tax organizer can also be useful,
and letters can specifically encourage clients’ completing one.

Business considerations of the engagement should also be
covered, such as payment terms, retainers, expenses, and
additional fees. Firms may also wish to address risks of data security.

John F. Raspante (johnr@naplia.com) is director of risk management for the North American
Professional Liability Insurance Agency (NAPLIA) in Framingham,
Mass. Stephen Vono (stevev@naplia.com) is vice president–CFO and a founding owner of NAPLIA.

To comment on this article or to suggest an idea for another
article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

AICPA RESOURCES

Publications

The Engagement Letter: Best Practices and Examples (#APAEGLO,
online subscription)

For more information or to make a purchase or register, go to cpa2biz.com or call the Institute at 888-777-7077.

Website

Guides, checklists, and other tax practice management forms,
including sample engagement letters, are available to AICPA and Tax
Section members at tinyurl.com/3knheg9.

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